William L. Watts

‘Strong vigilance’ required amid risks to inflation developments

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LONDON (MarketWatch) — European Central Bank President Jean-Claude Trichet surprised investors Thursday, signaling that policy makers are likely to hike interest rates next month in order to keep rising food and raw-material prices from turning into a broader inflation threat.

At his monthly news conference in Frankfurt, Trichet said a move at the central bank’s next meeting was “possible,” but not a certainty. The 23-member Governing Council never commits to a rate move ahead of time, he said, adding that a decision will depend on incoming data.

The remarks boosted the euro to its highest level against the dollar since November. The euro
EURUSD,
-0.04%
changed hands at $1.3936 in recent action, up 0.5% from Wednesday. See more on foreign-exchange trading.

Trichet also omitted language seen in recent opening statements describing current interest rates as “appropriate,” a term long viewed as a signal rates will remain on hold.

“The language being used, both in the [opening] statement and in the Q&A, suggests that, unless some very negative force intervenes, the council will undertake this action,” said Julian Callow, chief European economist at Barclays Capital.

In the central bank's last tightening cycle, the use of the term “strong vigilance” signaled the intention to raise rates at the following meeting, and “there is no reason to think that things will be different this time,” said Marco Valli, chief euro-zone economist at UniCredit Bank in Milan. Read First Take on Trichet's use of the 'V' word.

Trichet said a rate hike shouldn’t be viewed as the start of a series of tightening moves, a factor that may have prevented the euro from pressing above the $1.40 level, noted Kathleen Brooks, research director at Forex.com.

He also said the central bank would continue to fully meet demand for loans from commercial banks across the euro zone over the next three months.

Some economists had argued Trichet was unlikely to significantly alter his tone since markets have already priced in substantial rate hikes over the course of the year. They also expected the central bank to prove more cautious in light of ongoing uncertainty over the fragile state of bond markets on the so-called periphery of the euro zone.

Too quick on the trigger?

Others contend that the European Central Bank’s overly alarmed by a near-term spike in inflation when a sharp rise in oil prices is likely to prove deflationary by undercutting growth prospects.

Euro-zone inflation hit a 2.4% annualized rate in February, according to a preliminary estimate by the European Union’s statistics agency, rising further above the central bank’s target rate of near but just below 2%. This target applies over the medium term, defined as roughly two to three years.

Also Thursday, staff at the European Central Bank raised their inflation forecasts, with 2011 inflation expected at 2.3%, falling back below target to 1.7% in 2012.

“Unemployment rates are in double digits in most euro-zone countries and only expected to decline very slowly. And the ECB projects inflation to come back down to 1.7% next year,” said Marie Diron, senior economic adviser to the Ernst & Young Euro-zone Forecast.

“We do not think that this creates an environment that requires interest- rate increases. Instead, we think that raising rates prematurely would be a policy mistake,” she said.

Investors are nervously eyeing controversial talks on a compromise package of euro-zone economic reforms, seen as a prerequisite for Germany to give its approval of a more robust rescue mechanism for the region.

The central bank’s biggest fear is near-term inflation pressures becoming entrenched through “second-round” effects, such as feeding through to wage settlements and boosting inflation expectations.

Trichet said that there were no signs of such effects so far but that policy makers stand committed to preventing such a development. Inflation expectations currently remain anchored, he said.

Some economists contend a rate hike may be premature, particularly since peripheral euro-zone countries are facing headwinds as they continue to implement strict austerity measures in an effort to bring down burgeoning debt levels.

“In our view, the ECB is preparing to raise rates too early,” Barclays’ Callow said. “It should give the euro area economy more chance to get on sustainable footing, particularly since it is still too early to tell how the intense fiscal consolidation in many countries will affect demand this year and next.”

Trichet, however, appeared to dismiss suggestions that lagging growth in the periphery of the euro zone would stand in the way of rate hikes.

The bank’s “primary mandate” is to deliver price stability to the 331 million euro-zone citizens, he said. “Price stability is essential for the poorest and most vulnerable” citizens of the region, he said.

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